March Madness: Something to Invest In

My favorite time of year has finally arrived as golf courses turn green and college basketball kicks into full throttle. As a University of Arizona alum and die hard Wildcat fan, I am obsessed with college basketball. Forget social events. Forget the gym. Forget travel – unless it’s basketball related my free time is on lock down. Unfortunately, it pains me that my Wildcats will not be competing in the greatest weeks of the sports competition. But that won’t stop me from watching and filling out a championship bracket or ten; after all, diversification is key.

March Madness is a period that many companies loathe due to the three-week span that causes billions of dollars in lost work production; networks move slower as employees find ways to stream games at their desks; one-hour lunch breaks turn into two; even the novice sports fan joins the comradery and bracket pools. It should come as no surprise that as an investment professional, I see the similarities between choosing investments and selecting March Madness brackets.

The Bluebloods

Filling out a bracket can be as intimidating as making investment decisions, and while some prefer sheer luck, others take a more reasoned approach. Take stock of the elite basketball programs like the Blue Bloods of the NCAA. They are the names you know – the tournament teams that always seem to advance: Duke, Kentucky, UNC, and Michigan State to name a few. Let’s not forget the Mike Krzyzewskis’, Tom Izzos’ and the Roy Williams’ of college basketball – coaches you wouldn’t dare bet against come tournament time. In investor speak, such names suffer from familiarity bias. People invest in companies, individuals and things they know. Typically, no one investment or asset manager is the best every year, so deeper analysis is warranted prior to choosing an investment that expands beyond a simple name. Rarely is an asset manager the best at producing superior results across every asset class. In order to build an optimal active portfolio, it’s important for a portfolio to be diversified across various asset classes and asset providers – not just the names you know. Value can often be added through the utilization of a boutique asset manager.

Until last year, a No. 1 seed never lost in the first round. So, it should come as no surprise when picking a bracket, it’s usually wise to select the highest seed to beat out their lower-seeded opponent. This outcome is fairly predictable, like the bond portion of an investment portfolio, or stocks referred to as blue chips, which are often perceived as defensive and less risky equity investments. Like No. 1 seeds, bonds are considered to have a fairly more predictable outcome, which is why the odds for selecting any of the top four seeds is perceived favorable. For the average investors, bonds play a very important role in the portfolio. They help bolster the portfolio, and often times insulate the portfolio during equity market selloffs, much like the performance of a No. 1 seed in your bracket. Predictability only improves the probability of success.

The Odds Are In Your Favor

Betting on the No. 2, 3 and 4 seeds is another astute risk. The No. 2 seed has only lost eight games in the opening round, and five No. 2 seeds have gone on to win the NCAA championship. In the last 11 years, only three No. 3 seeds failed to advance to the second round, and of the two Final Fours that did not present a No. 1 seed, the No. 3 seed took home the victory. Last but not least, as a 4-seed in 1997, the Arizona Wildcats became the only team in tournament history to defeat three No. 1 seeds, including the University of Kansas, to become the national champion. We have seen a number of upsets in NCAA play. The 2018 Arizona Wildcats are a prime example. They had the young David Robinson aka Deandre Ayton, which many believed would lead Arizona to the Final Four. Yet Arizona was obliterated by 13-seed Buffalo in the opening round. Comparatively, a security may look good on paper and has a clean balance sheet, but it may not translate into a good investment. For whatever reason, the stock could be missing a catalyst. Every investment has some degree of risk, so using logic is important. Betting it all on the 16-1 is like buying a company that just filed Chapter 11 Bankruptcy. You might as well throw your money in the trash because in the history of the NCAA Tournament, there has only been one 16-1 upset. The trick is to invest with your head not your heart; avoid emotional picks and find value in the under-seeded team when others may be over seeded.

Investments & Bracketology

The parallels between investments and bracketology are evident. Bracketology is like an investment fund selection and stock rating. The NCAA Selection Committee uses a rating system based largely on game results, opponent quality, scoring margin, and net offensive and defensive efficiency. This NCAA evaluation tool (NET) replaced the former Rating Percentage Index (RPI), leveraging machine learning techniques for team performance data analysis. In most instances the safe bets triumph. This method would suggest simply picking the team with the highest NET rating in every match up. Some may prefer to even use the KenPom rating system. This same type of approach is very similar to merely selecting an investment because of its fund, stock and/or investment rating. Or with the rise in FinTech, it is like applying a purely quantitative investment approach to the selection and evaluation of investments, that leverages algorithms to perform fundamental analysis. At the end of the day, this is a very systematic approach; one that removes emotions and other factors from the equation and gives way to understanding risk statistics and characteristics. However, it is important to remember that past performance is no indication of future results; just because a team or investment is rated high, doesn’t necessarily translate to superior outcomes.

Another option for selection is working off of averages and targeting a sum for the Final Four. Over the past 25 years, 11.2 was the average sum of the top seeds. In 2017, the Final Four consisted of #7 ranked South Carolina, #1 ranked Gonzaga, #1 ranked UNC and #3 ranked Oregon, making the sum of their ranking 12. However, if you picked all number one seeds to make it to the Final Four, your sum is 4, which is a highly unlikely grouping. This is very similar to an investor’s risk profile. Clients are encouraged to complete a risk questionnaire, gauging how much risk they’re comfortable taking with their underlying investments in order to achieve their desired return. Typically, higher risk should lead to higher returns, but may also result in greater losses. The goal is to find the right balance of risk and reward, allowing the investor to reach their goals with an exposure to risk they are comfortable with. As earlier referenced, the No. 1 seeds’ predictability and risk factor align with bonds. This would be similar to constructing a portfolio made up solely of bonds; which doesn’t mean you won’t achieve success. However, if your goal is to earn a return of 6-7%, and you’re comfortable with the risk, then you’re going to need to take a little more risk to reach your objectives. Just like you’ll need to take some risks on teams not seeded No. 1.

Feeling a Little Risky

Choosing the popular 12-5 upset is a great way to expose a bracket to calculated risk. The 12-5 upset is one of the more popular in NCAA tournament history, and has occurred 47 times since 1985. While prevalent, the 11-6 upset is 3% more common, having occurred 51 times since 1985, including last year’s Loyola-Chicago Ramblers defeating the Miami Hurricanes and Syracuse upsetting Texas Christian University. Picking at least one or two of these match-ups to advance rather than the random 14-3 or 15-2 is strategic in moving past the opening round. You can compare this to an investment portfolio that adds exposure to risky asset classes, like investing in Emerging Markets. While the historical track record of the asset class may be volatile and unpredictable, it often comes with greater return potential. For the average investor, it’s probably not appropriate to put all of one’s investments in one asset class. However, the addition of such an asset class to a globally diversified portfolio oftentimes leads to increased diversification through the reduction of correlation, which typically leads to a less risky portfolio. The goal is to add only enough exposure to the asset class so not to push the entire portfolio outside your own risk comfort zone. This approach to finding your risk profile would be considered more calculated, much like the 12-5 and 11-6 upsets.

Another consideration is selecting the right matchup, perhaps putting a double-digit seed through to the Sweet 16. Since 1983, only two years encountered a double-digit team not advancing past opening week. In recent years, at least three or more have advanced as Cinderella stories. Take last year’s 11-seed Loyola-Chicago Ramblers who made it to the Final Four. They were the exception to the rule because typically teams lower than nine seeds don’t advance to the Final Four. Like investments, the key to a bracket is choosing the highest number of correct outcomes and focusing on value rather than focusing on one game. Sure, you picked the correct 14-3 upset and had them going all the way to the Elite 8, only for them to lay an egg in the Round of 32, busting your bracket. Building a portfolio of fundamentally strong and stable investments will provide the best end outcome. If you’re going to take risks, take calculated risks; knowing you need growth out of your conservative portfolio, perhaps you determine it’s appropriate to add equity exposure, and you do so by adding value stocks as a calculated risk. Value stocks are like under-seeded teams – priced below its peers and centered around various factors, analysis and performance that make them appealing to investors. Concentrate on the long-term because it is not just about getting one pick right, it’s about getting the most right. Emotions and second guessing can hinder your success.

Emotional Investing

Whether flipping a coin or selecting the most talked about teams on social media, removing emotional bias to make an objective selection, particularly when your favorite team is playing, is difficult. Your alma mater is unlikely to win it all, unless they are a 1-, 2-, or 3-seed in the NCAA Tournament. I’ve picked Arizona to go the Final Four countless times, when I should have been honest with myself. Emotional and wishful decisions can cost you, just like holding on to a stock too long, hoping it will rebound or praying its future investment potential is on the horizon. Emotions can negatively impact our financial well-being. This is why investors hire professional money managers. Good money managers have a time-tested process, allowing them to remove emotion from the equation and make sound objective decisions. The average investor rides an emotional roller coaster over the course of an investment cycle. The fourth quarter of 2018 is a perfect example. As volatility mounted, investors suffered from complacency bias, where they believed the market would behave just as it had during recent corrections. When the readjustment never took place, investors worried, which led to more selling. When the selling never subsided, they panicked and sold more.

Extreme market movements, both positive and negative, are typically a result of overreaction and should encourage individuals to stay true to a process. The emotional roller coaster of bracketology is very similar. Not winning the early rounds of the tournament or selecting a top team that was an upset can be stressful. No one likes a busted bracket. When you believe it is improbable, use logic to win and remove emotional bias.

March Madness encompasses more than just basketball. Statistics, money, comradery, investments and entertainment – everyone has a way of filling out their brackets. The highest seed is not always the winner, but understanding the rationale and odds behind seeding is an important step in winning your office pool. Consider the odds and perhaps you don’t pick your favorite team – unless they are really good. Diversify by entering several brackets and consider some of the smart risks outlined above when making a selection. And always remember, past performance is no guarantee of future results. Let the madness begin!

Chris Osmond is the Chief Investment Officer at PCIA. Bringing 13 years of experience to his role, Chris has won numerous awards for his work in wealth management and financial services. Chris received his Bachelor of Science from the University of Arizona, and is a Certified Financial Planner, as well as a Chartered Financial Analyst.